Monetary versus Fiscal: an odd debate

A long time ago, the debate between monetarists and Keynesians was the debate in macro. But it was a rather limited debate: both sides generally used the same model (IS-LM), and so it was all about parameter values. It was also, dare I say, a little dull. More recently, but before the recession, that debate had largely gone away, but since then it seems to have come back. This post asks why that is.

Before the recession, what I have called the consensus view was this. Under flexible exchange rates, monetary policy was the instrument of choice for demand stabilisation. Textbooks tend to give you a list of reasons why this is, but as I and colleagues argue here, it follows naturally in a New Keynesian model. It is not because fiscal policy cannot stabilise demand, but because (in fairly simple cases) monetary policy is better at doing so. From a welfare point of view, it dominates.

Does that mean, when monetary policy is unconstrained, it is all you ever need in a New Keynesian framework? In theory no. To take just one example, in a model with wage and price stickiness, real wages will deviate from their natural level following shocks, and in principle changes in income taxes or sales taxes could correct this. Even more obviously, these same taxes can in principle offset cost-push shocks. However you might describe this as a niche role for fiscal policy: the basic and fundamentally necessary task of stabilising demand is best handled by changing interest rates.

The qualification that monetary policy is unconstrained is critical, of course. If you are a member of a monetary union, it is a completely different game, and now fiscal policy’s ability to influence demand makes it useful, although perhaps not essential. I have argued that a failure to understand this was a major factor behind the Eurozone crisis.

The other example of a constrained monetary policy is of course the Zero Lower Bound. At the ZLB we have fiscal policy versus unconventional monetary policy. There are good reasons for thinking that unconventional monetary policy will not dominate fiscal policy as a stabilisation tool. Analysis of one particular unconventional policy, forward commitment (which is not the same as forward guidance), shows fiscal policy is not dominated in this case.

So which is better comes down to parameter values and the details of the model used. Given the uncertainties here, the only reasonable approach to take in advising policymakers is to use a combination of both policies. If you are thinking that concerns about debt might rule out using fiscal policy, you are wrong: temporary balanced budget changes in government spending can still be a useful tool.

This eclectic approach seems to me to be the one taken by, say, Paul Krugman or Brad DeLong. What I do not understand is why there are others who take a different view, and want to argue that monetary policy is still all you need. Where does this certainty about the powers of unconventional monetary policy come from? As I have already noted, it does not come from the theory that I know. So maybe it comes from a belief about parameter values, but given how untried this policy is, how can you be so certain as to not want to hedge your bets with fiscal action?

But perhaps it’s not the effectiveness of unconventional monetary policy that is crucial here, but a profound mistrust concerning the effectiveness of fiscal actions. Yet I cannot see the macroeconomics behind that either. In its purest form, all fiscal stimulus involves is bringing forward public spending, just as monetary easing encourages the private sector to bring forward their spending. That is bound to be effective in combating demand deficiency. Is the fact that the spending takes place this year rather than in five years time that costly, particularly if the spending is investment like in character?

So I remain mystified where this desire to downgrade the usefulness of fiscal policy at the ZLB comes from. I suspect I am missing something, and would like to know what that is.